New Issue: Basel Committee Agreement analyzed
The 8% Cooke Ratio lives on! A number selected rather randomly in 1987 has become the Pole Star for global capital regulation. It did not change when the Market Risk Amendment was added. It did not change after the East Asian and Russian market meltdowns in the late 1990s. It did not change as the basis for calibration when Basel 2’s models-based calculation methods were introduced. And now it has not changed as the basis for calibrating the capital framework after the largest financial crisis in living memory. Of all the possible outcomes associated with the G20 reform process, this consistency of calibration for “minimum total capital” is stunning. However, it would be a grave mistake to conclude that the fixation on the 8% means the Basel Committee has backed away from reform. When the various buffers have been added, minimum capital requirements increase to 10.5%. And the Basel Committee is only getting started.
This issue of The Risk Telescope suggests that far more important reforms are embedded in today’s agreement beyond the bottom-line number. The capital ratio has been redistributed between portfolio risk and systemic risk; the universe of instruments banks can use to meet the new requirement has narrowed. These redistributions and redefinitions will change the business model of banking as we know it. In addition, “systemically significant” banks (a term still not yet defined) will attract additional requirements including, says Basel, possible “combinations of capital surcharges, contingent capital and bail-in debt” and, possibly special “resolution regimes.” By year-end 2010, large financial firms may yet face a new environment that requires them to post far more capital above and beyond the 8% minimum standard.
Today’s agreement also signals subtle but important evolutionary priorities within the Basel Committee. The original 8% Basel I standard applied to the systemically significant banks of its day (“internationally active” banks). Basel II backed away from the calibration, saying that the overall amount of capital in the system would remain the same, but it would be re-distributed across the system so that riskier banks held more capital than well-managed, well-hedged ones. And the U.S. refused to implement it for any banks except internationally active ones. Today’s Basel III agreement signals a mean reversion back to the 8% calibration (plus a separately identified buffer) for all banks, as well as a major U.S. concession that global standards will apply to all U.S. banks, even if they are not internationally active. In addition, requiring all banks to hold buffers attributed to an imputed contribution of systemic risk represents a major shift in perspective beyond balance sheet risks, particularly when paired with the prospect of requiring a subset of “systemically significant” firms to meet additional, as yet unspecified requirements including possible issuance of new (experimental) debt obligations.
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